Of Janet Yellin, Dot Plots And Definitions

After listening intently to first the FOMC statement and then the ensuing press conference, the question apparently on investors' minds was: When a change is made to the Fed's statement on monetary policy, and yet the statement itself stresses that the change doesn't represent a real change, did anything a change, or not?

Continue Reading Below

By now, most of you are probably well aware of the fact that, in her first meeting as Chair of the Federal Open Market Committee (aka "the Fed"), Janet Yellen made some adjustments to the "guidance" that relates to what to expect from the Fed in the future.

Based on the reaction of the algos at Virtu, Getco, Citadel, Goldman Sachs (NYSE:GS), JPMorgan (NYSE:JPM), et al, traders did not like what they heard.

Immediately following the release of the Fed statement, the S&P 500 (NYSE:SPY) dove 10 points. However, that is a pretty typical response to Fed announcements. No, the bigger problem came later during the Q&A session of Yellen's press conference.

What Changed?

Advertisement

For starters, Yellen dropped the 6.5 percent unemployment rate "threshold" that, up to this point, had been viewed as the trigger that would cause the Fed to begin making changes to monetary policy. And while selling stocks on this may have been programmed into the algos, the move was widely expected.

Yellen explained that, instead of a pre-set line in the sand (aka 'quantitative-based guidance') that Ben Bernanke wanted the markets to be able to see at all times, the Fed was moving to something a bit less transparent, something that was, well, a lot more Fed-like.

In short, Yellen said the FOMC would now be watching what is being referred to as the 'Yellen dashboard.' As has been the case with the vast majority of her predecessors, Yellen declined to detail exactly what she and her fellow Fed Governors will be focusing on. However, the new Fed head did mention that the indicators will include data on employment, inflation, and overall financial conditions.

This too may have caused some selling. But, again, it was also expected.

In addition, the FOMC members cut their forecasts for the rate of unemployment (a good thing) for 2014, 2015, and 2016. There was also some improvement in the forecasts on the outlook for the economy.

However, at the press conference Yellen made it very clear that the new guidance provided by the Fed does not reflect a change in overall policy intentions.

The "Dot Plot"

Although Fed Chair Yellen also cautioned against reading too much into the so-called "dot plot," (the prediction of the Fed Funds rate from each Fed Governor is plotted on a chart -- see below) the bottom line is the median target for the Federal Funds rate at year-end rose for both 2015 and 2016.

Year-End Federal Funds Target - AKA The "Dot Plot"

For those not well versed in fed-speak, this means the median year-end target for the Fed Funds rate in 2015 is now 1.00 percent. The problem is, this is up from the 0.75 percent level from the last plotting of the dots. And then the median prediction for the Funds rate at the end of 2016 rose to 2.25 percent from 1.75 percent.

There are two points to be made. First, let's keep in mind that the current target for the Fed Funds rate is 0 - 0.25 percent.

Second and more importantly, the current dot plot suggests the FOMC will begin hiking rates sooner and/or more aggressively than previously thought. NOW we're talking. NOW the algos had something to sink their teeth into.

While this sounds like a logical explanation for the Dow's (NYSE:DIA) triple-digit decline, the bottom line is the big dive didn't happen until Yellen started answering reporter questions.

Getting Some Clarity

But how do we know that it was something Yellen said, and not the combination of the changes (that weren't supposed to be changes)? By watching the one-minute chart of the stock market, of course.

As the new Fed Chair's press conference wore on (and on), suddenly, out of nowhere, the DJIA dove 170 points in less than 10 minutes. This, dear readers, is how you KNOW something is up.

It turns out that Janet Yellen had, whether intentionally or not, provided some clarity on what a "considerable" amount of time was. And based on the reaction in the market, this was a surprise - and not the good kind.

Recall that in the Fed's statement, the committee had said the benchmark federal-funds rate would remain near zero for a considerable time after the QE bond-buying program ended. Then, for the first time, Yellen attempted to define that term -- saying it was hard to define but probably means something on the order of around six months.

Wham! Down she went.

Here's the problem: the consensus expectation for when the Fed will start raising interest rates is sometime in the third quarter of 2015. However, with the QE program set to taper to zero by year end, this means that Yellen and Co. could start raising rates in June. And the bottom line is this is EARLIER than expected.

THIS was something new. THIS is why the S&P was pounded for one percent in under 10 minutes. And THIS is why traders were suddenly freaking out.

Granted, stocks recovered about half of the algo-induced dive into the close. But it is worth noting the markets don't like surprises, and THIS is the type of surprise that could be with us for a while.